Thursday, September 18, 2014

America’s Interest-Rate Puzzle

A great puzzle in today’s world economy is the continued low level of long-term real interest rates in the United States. Conventional macroeconomists like me look at America’s current-account deficit, now running at 7% of GDP, and know that such vast deficits are inevitably followed by large currency depreciations. So we expect a substantial depreciation premium on US interest rates.

If the dollar falls 20% more against the euro sometime in the next ten years, US long-term interest rates should be two percentage points higher than euro rates. If it falls 40% against the yen sometime in the next ten years, US long-term interest rates should be four percentage points higher than Japanese rates. If it falls 60% against China’s currency, the yuan, sometime in the next ten years, US long-term interest rates should be six percentage points higher than Chinese rates. But we are not seeing signs of anything like this.

The puzzle is not only that long-term rates are too low when viewed in the international context, but also that they are too low when viewed in America’s domestic context. The Bush administration continues to have no plans to sew up the veins it has opened with its medieval economic policy, which holds that bleeding revenue from the government cures all economic problems.

This means that unless America’s domestic savings rate rises mightily – which it shows no signs of doing – and unless investment expenditure remains abnormally low for the rest of this decade, the supply of loanable funds to finance investment will soon be much less than demand when the current-account deficit narrows to sustainable levels. But when supply is less than demand, prices rise sharply.

In this case, the price of loanable funds is the real interest rate. An expectation that interest rates will be high sometime in the next decade should mean high interest rates on long-term bonds today.

Yet financial markets are not pricing dollar depreciation and a rise in long-term US interest rates accordingly. When we macroeconomists talk to our friends on Wall Street, we find that they don’t view this as a puzzle at all.

On the contrary, they are puzzled about why we view the current low level of US long-term interest rates as worrisome. From their perspective, today’s high demand for long-term dollar-denominated securities is easily explained: Asian central banks are buying in order to hold down their currencies, the US Treasury is borrowing short (and thus not issuing that many long-term securities), and US companies are not undertaking the kinds of investments that would lead them to issue many long-term bonds.

But for every market mispricing there is a profit opportunity: if long-term interest rates are, indeed, too low and long-term bond prices too high, investors will short long-term US bonds, park the money elsewhere, wait for bond prices to return to fundamentals, and then cover their short positions. By doing so, they will push prices close to fundamentals today.

Wall Streeters, however, offer a counterargument: for any financial institution to, say, bet on the decline of the dollar against the yuan over the next five years in a serious, leveraged way is to put its survival at risk should the trades go wrong. And trades do go wrong: remember the collapse of Long-Term Capital Management.

The existence of large financial-market actors that do not care about maximizing their profits magnifies the riskiness of the bets. If, say, the Bank of China and the Federal Reserve decided to teach speculators a lesson by pushing the dollar’s value relative to the yuan up by 20% for a month, they could do so, bankrupting many financial institutions with short positions.

Similarly, any financial institution that bets on a sharp rise in long-term interest rates over the next five years in a serious, leveraged way also puts its survival at risk. For where should they park their money?

Real estate rental yields and stock-market payouts are low, and real estate and stock prices may well fall as much as or more than bond prices if interest rates spike. Only businesses that can borrow long-term now, lock in a low real interest rate, and invest in expanding their capacity can make the domestic bet that interest rates will rise. But America’s businesses see enough risk in the future to be wary of getting stuck with unutilized capacity.

Economists believe that market forces drive prices to fundamentals. But we are not careful enough to distinguish situations in which equilibrium-restoring forces are strong from those in which such forces are weak. The dollar will fall and US long-term interest rates will rise, but only when traders on Wall Street and elsewhere decide that holding dollars and long-term US bonds is more risky in the short run. When that happens, the long-run future will be now.

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